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Tariffs and quotas in the presence of foreign monopoly

Article  in  The International Trade Journal · March 1987

DOI: 10.1080/08853908708523618

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 CONTENTS

Cy
~:---l_ ;:.:blished for the
=-=-- :::lai objective is to THE
·",a:~::-" findingsin, and
- ~ ::--_c ~:tld.
VOLUME I, NO.3 INTERNATIONAL
SPRING 1987 TRADE
:::'_:_::-~ not only from
.:;.ernational trade
JOURNAL

ARTICLES
'-.;e :.:ik,,,;ing:
U.S.-Canadian Trade Liberalization
and Adjustment Mechanisms: A Survey
Alan M. Rugman and Andrew Anderson. . . 219
Protectionism and The Case for Flexible
~=je:-::s
Exchange Rates: A Reexamination
Williard E. Witte. . . . . . 251
Raw Materials Price and Technology
_' :a':::5 given, are those Uncertainty in a Small Open Economy
:~:-:Ce-:[the position of
Jon D. Harford and Keehwan Park. 277
_::;; T r ade: nor tha t of
.~-.-,; . Tariffs and Quotas in the Presence
of Foreign Monopoly
F. R. Casas and E. Gelbard .. . . . . . . . . . . . 289

NOTES
The Choice of Appropriate Technology
in a General Equilibrium Model
:=:.v cv the Institute ot
,~~:-s .: the University Bernard Yeung .... . ... 305
::L Y_ce President for
.s.on of Business BOOK REVIEWS
;-_ :-.. . :e :.Jr Inrernational
Glenda Korporaal, Yankee Dollars:
: cc 50: a:c: are Khosrow
Australian lnuestrnent in America
c: ~.ae::ben, Professor
::-:::::-_.i.[ion, all from Reviewed by Paul Garner . . . . . . 315

I .
 TARIFFS AND QUOTAS
IN THE PRESENCE OF
FOREIGN MONOPOLY

F. R. Casas

E. Gelbard

,:ewers to assist the Tl:: paper contrasts t be effects of tariffs and quantit atit:e restrictions
:ed for publication or :<: .c: presence of a foreign monopolistic exporter. It is shown ib«: a tariff
wo;.;.: in auce a Lerner-type effect in the t arifj-im-posing country whereas a

the Journal in its ~:.~ z: t: ill necesarily have such an effect. More generally, a quota will
:. ~~.celi the terms of trade more tbun the equivalent tariff, altbough the
<end a copy of their
.<:«: 1£'1 monopolist may not capture the entire scarcity rent produced by the
.J:'~:'; These results have significant implications when t be relative costs of
:';~lc:H trade barriers are evaluated.

,~ Trade Journal I~TRODUCTION

versiry
.:;.:-)
Among the standard results in the theory of commercial policy are the
ertecr of tariffs and quotas on domestic prices and on the terms of trade. For
'" '" '" '" '"

FR. Casas is Professor of Economics at University of Toronto.

E Gelbard is a member of Department of Economics at University of

Toronto .

•; ",' .''C.I; THE INTERNATIONAL TRADE JOURNAL. Volu-me I, No, 3. SprrnR 1987 289
290 THE INTERNATIONAL TRADE JOURNAL

a country possessing monopoly or monopsony power in trade and under

perfectly competitive conditions, such trade restrictions are normally
expected to raise the domestic relative price of the importable commodity in
the tariff- or quota-imposing country while at the same time improving that
country's terms of trade. Exceptions to these results include the familiar
Metzler (1949) case, in which a tariff lowers the domestic relative price of
the im portable good in the presence of an inelastic foreign import demand,
and the Lerner (1936) case, in which a tariff worsens the terms of trade in
the presence of an inelastic domestic import demand. The importance of
these price effects stems from their implications for the allocarional,
distributional and welfare impact of trade restrictions.
Another widespread result in the literature on trade theory is the
proposition that tariffs and import quotas are qui valent. I Several authors,
including Bhagwati (1965) and Shibata (1%8), have shown that this result
may also be invalidated, particularly in the presence of monopolistic
elements in the import-competing industry, the foreign export sector, or
among the quota holders.
The objective of this paper is to further investigate the case where the
foreign supply of an importable good is monopolized and where inter­
national commodity arbitrage prevents the foreign exporter from price
discriminating across markets. In the following section we consider the
effects of a tariff and show that it may produce a Lerner-type effect which
differs in its source from the conventional case discussed in the literature. In
Section III the analysis is extended by com paring the price effects of tariffs
and quantitative restrictions in the presence of foreign monopoly. The
results obtained stand in contrast to those derived from the competitive
model. These results are compared with those in other studies, and the
paper concludes with some comments on the distinction between tariffs,
quotas, and voluntary export restraints and a proposed preference ranking
of such measures The model used throughout the paper is the familiar

I
This issue was first raised by Meade (1951, pages 173-185). See also Kindleberger (1958).
>E JOURNAL CaJ.s.zn4 Gelbard: Tariffs and Quotas . . . 291

Ide and under Ibbederian partial equilibrium model which has been traditionally employ­
are normally ed to compare the effects of tariffs and quotas.
commodity in
.nproving that n TARIFFS AND THE TERMS OF TRADE WITH A
e the familiar FOREIGN MONOPOLY
lative price of
wniIe a tariff normally raises the domestic relative price of the
]port demand,
iimporuble commodity subject to the duty, Metzler (1949) showed that this
ms of trade in
RY..:r.lt ffi.ay be reversed if the foreign demand for imports is price inelastic.
importance of
),lore recently, Casas and Choi (985) demonstrated that a Metzler-type
e allocational,
proidox may result from the existence of a decreasing-cost import­
a:;rnpeting industry - whether the latter is competitive or monopolistic/
theory is the
On the other hand, while a tariff normally reduces the foreign price of
-veral authors,
ttr importable good, a post-tariff increase in that price is described as a
:hat this result
Lerner paradox. A necessary condition for such a paradox to occur is that the
monopolistic
domestic demand for imports be inelastic or, equivalently, that the elasticity
oort sector, or ,
.JJl rhe domestic supply of exports be negative. However, we can establish
c:.~: J. Lerner paradox may also be obtained under a different set of
:ase where the Clrl7;.lIDSUnCe s.

where inter­
Consider the effects of a specific tariff imposed by a country which
er from price
cb:2ins irs imports from a monopolistic foreign supplier. The foreign firm
, consider the
stl~ its homogeneous maput in both the foreign and domestic markets, and
e effect which
a:;rn.modity arbitrage rules out price discrimination across markets. J In
e literature. In
~,m= 1. I page 292) we first illustrate the case where the monopolist
fecrs of tariffs
ionopoly, The
Ie competitive -Enger 19-1) had earlier shown that even when a tariff increases the domestic price of the
~",.ible commodity, the equilibrium Output of a monopolized domestic industry may fall.
udies, and the
'_'\5 shown by Chacholiades (1978, pages 172-175) the sum of the elasticities of import
erween tariffs, ~ ~ and export supply is -1. The necessary and sufficient condition is that the elasticity of
~hmesric supply of exports be smaller than the negative of the marginal propensity to
.rence ranking
aro;;:rme rhe exportable good.
5 the familiar
in "doer words, in spite of being the sole producer in the foreign market, the monopolist
~ poceruial resale between (he rwo markers.

::!leberger (1958).
 Figure I
Tariff with a Constant Cost Foreign Monopoly
 w,-.;" -,.Ii Gelbard: Tarijjs and QuotM ... 293

':'pe:-2res under conditions of coos cane cases. In the left panel, 0d shows the
'"' JDoes[ic country's excess or import demand, while Of is the foreign
~
a Jem2nd for rhe same commodity. In rhe righe panel, 0 is the weal demand
~~':- :ie foreign monopolise's produce, MR is rhe corresponding marginal
b
revenue, and MC is the (cons cane) marginal cost.

By reducing [he domestic import demand from 0d co O~ a tariff will

::-e-":~ce the total demand for rhe produce of the monopolise from 0 co I)"
,,-u": :-:-,2rginal revenue from MR co MR'. This will result in a decline in the
7:re:gn price from the free (fade level P co Pi and a rise in the domeseic
:.lr~if-irlcjusiveprice from P co P~. Ceteris paribus. chis is equivalene co the
.::,:::yemional result that a eariff improves [he tariff-imposing country's
:E~=5 cf trade.

The presence of increasing costs in the foreign industry would nor

.=':":':::2ei\'ely affece these results, as may be readily ascertained by drawing a
?:-si::"eh'sloped MC curve through E in Figure I (page 292). Increasing
::-:.,:, 7"mld merely reinforce rhe downward pressure on the foreign price
-::__e :-21sing the domestic price less chan in the constant cost case.

~ The case of a foreign monopolise with decreasing costs is depicted in

Eg'::-e II page 294). Here, the eariff increases bor h the foreign and the

~
3:':::e5:ic prices from P co Pi and P'd, respeceively.' Thus while a necessary
:D::":i:ion for the conventional Lerner paradox is that ehe domestic export
-0 :;:..2FF::: have a negative price elasticity, we h.ive established rhar the
a
s:::.?:'i:ion of a eariff may worsen the eariff-imposing country's terms of
:rl::e ::1 the presence of a decreasing cost monopolistic foreign exporter.

~
:: ,- .'3[h noring that while stability of equilibrium requires Me to be flatter than MR at
= c .:c:e:5eCtion, the foreign price will decline if the Me curve is steeper than the demand
:...:.::

292

 Casas and Gelbard.

It is importar
foreign industry is
IC8eaing the exist,
indiTidual firms b
dro:easein the rota
die foreign price it
....w be higher t

iDe, K5 COSts for ;

>. - Ai
00.. ITa
0 ex]
c
0
~
c
.~
...0
(1)

-...
(1)

::l
~

U
....til
0

.~ ~
~ ";;;
t'l
...u
(1)

(1)

c
t'l
..c::
....
"~
.....
.....
";::
t'l
f-<

294

 "

c.r.s- ..d Gelbard: 'Fariffs and Quotas . . . 295

It is important to note that the same result will be obtained if the

c
foreign industry is perfectly competitive with decreasing long-run costs

~Q
reflecting the existence of pecuniary or technical economies external to the
iadividual firms but internal to the industry. While the tariff-induced
tk:rease in the total demand for the foreign industry's product would lower
the foceign price in the short run, the long-run equilibrium foreign price
r:::: would be higher than under free trade as contraction of the industry
;::s
iIII:reases costs for all firms. We may therefore state the following result:

1~:\Pmposition 1 - A tariff may worsen the tariff-imposing country's terms of

trade in the presence of decreasing costs in the foreign
export sector.
._------_.Qi
kfollows that the Lerner paradox may derive from decreasing costs in the
~tic export sector (the conventional case) or in the foreign export

-----"""""'10 NON-EQUIVALENCE OF TARIFFS AND QUOTAS WITH A

FOREIGN MONOPOLY

Bhagwati (1965) was the first to show that the introduction of market

~
imperfections in the form of monopoly in the import-competing sector or
~
BDOOg importers (that is, quota holders) would invalidate the notion that a

a Driff and an alternative quota set at the post-tariff level of imports would be
equivalent. Using a definition of equivalence based on the domestic price

and allocative effects of the two policies, Yadav (1968) and Shibata (1968)
argued that tariffs and quotas would be equivalent if monopoly power
resides either in the hands of the importer or the foreign exporter.
However, it was left for Bhagwati (1968,1983) to conclusively demonstrate
that if equivalence is defined as equality between an explicit tariff and the
implicit tariff produced by the quota, any departure from perfect competi­
tion anywhere in the trade process would yield non-equivalence."

294

1
i
296 THE INTERNATIONAL TRADE JOURNAL

In the case where monopoly power resides in the import-competing

sector and where the domestic country is small in the world market for its
importable, non-equivalence is explained by the fact that whereas a tariff
does not allow for the emergence of monopolistic elements, a quota does so
by imposing a quantity constraint to international arbitrage. In the case of
an importing country which possesses monopsony power in the world
market, Casas and Choi (1985) have argued that even though a tariff would
not prevent the import-competing sector from exercising its monopoly
power, non-equivalence would be obtained because a quota would expand
that power by reducing the elasticity of the net or residual demand for the
domestic Output. In both the small and large country cases, a tariff yields a
lower domestic price and a higher domestic output than the equivalent
7
quota.

The presence of a foreign monopoly also yields non-equivalence

between tariffs and quantitative restrictions. Such a case is particularly
relevant in the comparative analysis of the effects of tariffs and voluntary
export restraints (VER) the use of which has become widespread among
North American and Western European nations as part of their trade
policies towards Asian exporters. While there may be several foreign
suppliers, the need to allocate the de facto quota produced by the VER often

6
Kreinin (1970) has argued that non-equivalence prevails even under perfectly competitive
conditions if dynamic considerations --such as the effects of changes in demand or supply
conditions in the presence of tariffs and quotas-- are included. Rodriguez (1974) also showed
that tariffs and quotas would produce different final equilibria if retaliation is taken into
account. Finally, Fishelson and Flatters (1975) compared an optimal quota in the presence of
uncertainty with a tariff yielding the same expected level of imports and concluded that they
would not generally have the same welfare effects.
7
Rieber (1986) has extended these results by showing that with a monopolistic import-
competing sector, an import quota set at or above the free trade level of imports may
paradoxically increase the domestic price of the importable commodity.
 .. TRADE JOURNAL
:::e import-competing
·,t world market for its
.: ::-tar whereas a tariff
t::1enrs, a quota does so
,:'::, .trage, In the case of
. F"::,,,,'er in the world
:: :~iough a tariff would
:t:cising its monopoly
2 cuora would expand
:o,,:-:~al demand for the
-, cases, a tariff yields a
~: than the equivalent
.e.cs non-equivalence
2 case is particularly
:: .ariffs and voluntary
:=t widespread among
25 part of their trade
2 ',' be several foreign
i~ctd by the VER often
_~,,,er perfectly competitive
"c,;e, in demand or supply
C;:"EZ (1974) also showed
~ :Euliarion is taken into
C":',", ccora in the presence of
,C:' ",1C concluded that they
',: .•, 0 monopolistic import­
.""~ .ev el of imports may
L.;_',;,- ';Iid Gelbard: Tariffs and Quotas, , , 297
£2::5 :0 some form of collusive agreement among the foreign suppliers that
C;D oe conveniently approximated by the monopoly assumption.'
Consider the case of a foreign monopolist that sells its product in the
:.::t:gn market and competes with a perfectly competitive industry in the
-:c:ntstic economy, Potential resale across markets prevents the foreign
=x~,orrer from adopting price discriminating polices,9 In Figure III (page
=':JcS we illustrate the effects of an import quota equal to the post-tariff level
z: .rrpor ts (OM in Figure I, page 292). D" represents the quota-inclusive
:::31 demand for the foreign firm's product, and MR" is the corresponding
=..1: i,:inal revenue curve. The quota increases the foreign price from P to Pf
3:1': reduces the foreign output from Q to Q". While marginal cost was
1.55'.:.:ned to be constant in Figure III, it is readily shown that these results
[).::': regardless of the slope of the Me curve. 10 Thus, an import quota always
;:.:02uces a Lerner-type effect against the quota-imposing country, and we
=.<; therefore state the following result:
0,,0 (1984) discusses a case in which a foreign monopolist is part of an oligopoly in the
;]:::C~5:ic economy. Unlike a tariff, a quota or a VER would then facilitate tacit collusive
...: ,c:,'CDS between the foreign monopolist and the domestic firms. Harris (1985) argues that a
-,-'OR :T<al induce price leadership behavior by domestic firms. In both models, the decline in
~:r,"C:cler welfare under a quota is greater than under a tariff because of the quota (or
',-=:R -i nduced lessening of competition. A similar result was also obtained by Iroh and Ono
::;; ~ "sing a Stackelberg duopoly model in which a domestic monopolist confronts a foreign
;:~·~e discriminating monopolist.
Tr.is assumption may also be justified by the presence of ami-dumping regulations in the
J- ~e-sr!c country.
"The reader is reminded that Figure III cannot be used to analyze the effects of a quota with
Me curves since the import quota itself would have
.:..:'-'~rEnr to be adjusted to the
:::-re,ronding post-tariff equilibrium level.
-

Guas and Gelbard: Tar

Proposition 2 - In the
aVER
terms
price 0
the for
it ever

It is worth observi
domestic country's ten
IIImpetitive, a quota will
willie a quota may incre:
. ..ill occur if and on
as the tariff woul
c-,
"0
0..
0
c
...... 0
......
...... ::E
<l.l
.... c
;j
Q.Q
.::P
<l.l
....
i.L: 0
il-<
.c...
.~
...'"0
;j
QI _1H!11S(:riminating sUPl
ill illustrates the'
me foreign expor
Pf in both n
prevents the fi
will be cleared at

scarcity rent ec
under Bhagwat
ill, page 298) unc
(PJ-Pf in Figure I.
298 'lbe residual rent r:
 ~

Tariffs and Quotas . . . 299

u
::8 r - -M' 2 - In the presence of a foreign monopoly, an import quota or
a VER will always worsen the quota-imposing country's
terms of trade. Where a tariff would increase the foreign
price of the importable good because of decreasing costs in
the foreign industry, the equivalent quota would increase
it even more.

• is wonh observing that while a tariff may improve or worsen the

------------tIO
- - - - - - - - - - - - - ... ::8
• COUntry's terms of trade if the foreign industry is perfectly
- - 'e, a quota will have the same effect as the tariff in that case. Thus,
aepora may increase the foreign price of the importable commodity,
oa:ur if and only if a tariff would also increase it and to the same
_ me tariff would increase it.
remaining issue is the allocation of the scarcity rent produced by
In his analysis of the effects of an import quota, Shibata (1968)
that the foreign monopolist sells all its output in the domestic
and then showed that the monopolist would extract all the scarcity
is, the foreign price would increase pari passu with the domestic
"DIe implicit tariff rate associated with the quota is zero in this case,
of the value of the equivalent explicit tariff.

------
IIowever, our analysis has assumed that the foreign monopolist is a
Mliscriminating supplier in both the domestic and foreign markets, and
m illustrates the effects of relaxing Shibata's restrictive assumption.
the foreign exporter maximizes profits in the presence of a quota by
Pi'in both markets - under the assumption that commodity
prevents the firm from price discriminating. The domestic import
will becleared at P d' (equal to the equilibrium domestic price under
equivalent explicit tariff), implying that the monopolist will not capture
Q . . the scarcity rent equivalent to the tariff revenue. Non-equivalence
.....ins under Bhagwati's definition since the implicit tariff (P d' -P{ in
Figure III, page 298) under the quota is smaller than the equivalent explicit
ariff (Pd-Pi in Figure I, page 292), but the implicit tariff is not necessarily
298
JftO. The residual rent not captured by the foreign firm could be received by
300 THE INTERNATIONAL TRADE JOURNAL

the domestic holders of the quota rights or the domestic government if

quota licenses are auctioned off in a competitive fashion. We have thus
established the following result:

Proposition 3 - In the presence of non-discriminating foreign monopoly,

the scarcity rent produced by an import quota or aVER,
which an equivalent tariff would generate as revenue for
the domestic government, will not necessarily be entirely
captured by the foreign exporter.

This result runs counter to the conventional wisdom which holds that
the scarcity rent "may accrue to [the foreign] exporters, when the latter can
collude but [domestic] importers cannot."ll The reason that this may not
happen is that if potential resale across markets and/or anti-dumping
regulations in the domestic market prevent the foreign monopolist from
price discriminating, an increase in price above the profit maximizing level
Pf would raise the revenue from the sale of the quota in the domestic
market but not enough to compensate for the reduction in sales revenues in
the foreign market. 12 Clearly, whether the exporter captures the entire rent
or not depends, ceteris paribus, on the foreign elasticity of demand. It is also
evident that if the foreign exporter is able to effectively separate the two
markets and thus to price discriminate, the entire rent would always be
received by that firm.

IV. CONCLUDING REMARKS

We have suggested earlier that the analysis of the effects of an import
quota in the presence of foreign monopoly was particularly appropriate to
the study of the impact of voluntary export restraints. However, i~ should
not be inferred from this that quotas and VER's are equivalent policies

\l
See Chacholiades (1978), page 483.
12
The net decline in total revenue would also have to be larger than rhe.decrease in total
cost due to the reduction in the firm's output. "

~.4.L TRADE JOURNAL
domestic government if
e fashion. We have thus
oaring foreign monopoly,
n import quota or aVER,
.d generate as revenue for
nor necessarily be entirely
er.
wisdom which holds that
orrers, when the latter can
reason that this may not
ets and/or anti-dumping
foreign monopolist from
te profit maximizing level
Je quota in the domestic
uction in sales revenues in
er captures the entire rent
sticity of demand. It is also
.ecrively separate the two
ire rent would always be
)f the effects of an import
arricularly appropriate to
aints. However, i= should
's are equivalent policies
larger than the decrease in total
.
Tariffs and Quotas . . . 301
IDOOOpoly power would be exercised by the foreign explJrtcr under J II
scenarios. If VER's were to facilitate or promote collusive
IIIIJPOIistic behavior among foreign exporters, they would have to be
as inferior to quotas since the proportion of the scarcity rent
by those exporters would be higher (and the implicit tariff would
IIIIIft:rI under a VER than with a quota. The conclusion which emerges,
, is rhar tariffs should be regarded as superior to quotas and to
's in rhat order.
n.. fan that Western nations have been increasingly resorting to
quotas in recent years is attributable to a number of factors. First,
oations have had their policy options in the area of tariffs curtailed by
~mems reached under the successive rounds of GATT negotiations.
same time, quantitative restrictions an: favored by all parr icipat ing
because they facilitate collusive agreements, and these firms are likely
considerable political pressure. These restrictions are also less
for consumers than tariffs, adding to their attractiveness for
ems anxious to avoid a backlash from consumer groups. Finally,
possibility of naive behavior by the authorities cannot be disregarded.
Similarly, the growing recourse to voluntary export restraints may be
ted ro the attempt to circumvent the rising unpopularity of more
- nal non-tariff barriers such as explicit quotas. Some governments
also wish to avoid the problems and COStS of administering quotas or
ClXTUption often associated with the allocation of import licenses.
302 THE INTERNATIONAL TRADE JOURNAL
(Asas and Gelbar.

REFERENCES
11. Kreinin, M.
Kyklos, Volt
1. Bhagwati, J.N., "On the Equivalence of Tariffs and Quotas," III
12. Lerner, A.P.,
Baldwin, R.E., et. al., (eds.) Trade, Growth and the Balance of
Payments, Chicago: Rand McNally, 1965. Economica. '

2. , "More on the Equivalence of Tariffs and Quotas," 13. Meade,j.E.,7

American Economic Review, Volume 58, 1968, pages 142-146. London: Ox!

3. , "On the Equivalence of Tariffs and Quotas," in The I-t Metzler, L., "
Theory of Commercial Policy, Volume I, Cambridge: MIT Press, National Ince
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4. Casas, F.R., and Choi, E.K., "The Metzler Paradox and the Non­ 15. Ono, Y., "Prof
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16. Rieber, W.;., .
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10. Kindleberger, c.P., International Economics, Homewood, Illinois:

Richard D. Irwin, 1958.

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L Cambridge: MIT Press,
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irrher Results," Journal of
~es 53-57.
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es 345-354.
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CVIII, 1985, pages 799-809.
s and Market Structures,"
(CVIl, 1982, pages 295-305.
mics, Homewood, Illinois:
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10
Lerner, A.P., "The Symmetry Between Import and Export Taxes,"
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london: Oxford University Press, 1951.
Metzler, 1., "Tariffs, The Terms of Trade and the Distribution of
National Income," Journal of Political Economy, Volume 57,1949,
pages 1-29.
_ 000, Y, "Profitability of Export Restraint," Journal of International
Economics, Volume 16, 1984, pages 335-343.
Rieber, W.]., 'The Non-Equivalence of Tariffs and Quotas: An
Extension," Journal of Economic Studies, Volume XIII, 1986.
_ Rodriguez, CA., "The Non-Equivalence of Tariffs and Quotas Under
Retaliation," Journal of International Economics, Volume IV, 1974,
pages 295-298.
Shibata, H., "A Note on the Equivalence of Tariffs and Quotas,"
American Economic Reoieu., Volume 58,1968, pages 137-142 .
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Canadian Journal of Economics, Volume I, 1968, pages 105-110.